The primary stumbling block that prevents investors from achieving holistic fiscal health is mental clutter. Their minds are filled with the wrong questions. The right question is a prerequisite for finding the right answer.
One such wrong question, and the flavour of the season is: Where should I invest to save tax? PPF or ELSS?
I don’t even know where to begin answering this question because the question is wrong at so many levels.
1) If asked at the end of the financial year, it often betrays ignorance and apathy about goal-based investing. Try telling the person to, list goals, decide on asset allocation and then incorporate tax planning as an integral part of a long-term goal, and they would often react like you have not understood their question, get all jittery and impatient.
The simple truth is most people do not know how to process information. It amuses me to no end that such people cannot get enough of information: they read every article, every thread in a forum, subscribe to every blog, but cannot extract actionable steps from them. Neither will they seek professional help for the same.
2) It is an apples vs oranges comparison. How can you compare a fixed income product locked in for 15 years with a diversified equity fund locked in for 3 years?!
Purely from the point of view of a lock-in, most investors fail to recognise that dependency on tax-saving products is likely to decrease as income grows, because the mandatory products like EPF and NPS will the cover more and more of the 80C limit. So it is better to prefer products with a minimal lock-in. This allows you to chuck the product down the line.
So ELSS is a clear winner from this angle. The 3Y lock-in is the smallest and it is the most flexible. However, the underlying asset class, equity, is not meant for 3-year durations!
3) One cannot think of choosing equity without understand the nature of the stock market. You can stay invested for 3Y or 30Y, the volatility will never die down. So investors have no choice, but to get used to it. It is important to recognise that you invest some capital to save tax, but that capital could be lost due to stock market fluctuations. Over 3 years, the probability of loss is so huge that one cannot offer a meaningful estimate of expected returns!
This means that ELSS investors should continue to use them as long as they need the tax-saving and shift future investments and invested corpus to non-tax saving equity instrument. Otherwise, it would result in clutter and improper goal planning.
Thus before choosing a tax saving instrument, it is important to understand the nature of the asset class and act accordingly.
Wait a minute, understanding market volatility would take a while. So let me rephrase that:
Thus before choosing a tax saving instrument, it is important to understand that it is important to understand the nature of the asset class and act accordingly.
In others words, invest in ELSS, but be sure to start learning more about volatile compounding!
What is the way out?
Most of us would need to use tax-saving instruments until we die. Retirement is a goal that would outlive us if we have a dependent spouse. So tagging tax-saving instrument to the retirement is the most natural solution.
Since beating inflation is practically mandatory for retirement, we would need adequate equity exposure (60-70%). Meaning, ELSS is a natural choice.
Instead of ‘PPF or ELSS?’, the question ought to be ‘PPF or debt fund plus ELSS?’
Since the retirement corpus will not get spent in one shot, most of the accumulated corpus in the debt part of the portfolio would get spent gradually over a few years. Since debt fund gains are tax only upon redemption and to the extent of the redemption, I like debt funds more than PPF. It is far more flexible, even though many (if not most) debt funds may or may not be able to beat PPF returns over a 15 year period, due to the nature of the bond market and of course taxation.
My point is, while PPF is certainly not a bad choice, it is not necessary for tax saving. The danger of low interest rates in future must be factored in – most people fail to do that. Esp those who compulsively invest the full amount! Read why you should not do so.
One can invest only in ELSS funds with the rest in a debt fund (non-tax saving) in line with a set asset allocation, say, 70% equity and 30% debt.
Not suggesting that this is a better way. Just pointing out that there are multiple solutions to practically all questions in personal finance.
Understanding that would require asking the right questions. In this case,
To which goal should I tag my tax saving instruments?, and not, where do I invest? If the goal is clear, the instruments would become clear.
Those who seek the ‘best’ solution are confused because of their refusal to realise that there is none. The moment we embrace the possibility of multiple solutions, we are clear that all we need to do is to choose one solution that impresses us – counterintuitive, but true.
Embrace it, we must, for multiple solutions is the law of nature.
- with inputs from facebook group, Asan Ideas For Wealth.